Return on Invested Capital
Q: I read an article arguing that return on invested capital is the single most important investing metric. Is that true, especially from a value investor’s standpoint?
A: First, let’s start by answering the more basic question: what is return on invested capital (ROIC)?
Essentially, ROIC is a measure of how well a company uses its capital to generate profit. The basic formula is net operating profit after tax divided by invested capital (a combination of debt and equity). It’s worth noting that ROIC can actually be calculated several ways, but at heart it’s a measure that helps us understand how good a company is at making money from its capital – and thus creating value.
Now, to answer the larger question: yes, ROIC is extraordinarily important.
If you can identify companies that can take retained earnings and reinvest them back into the business into high return on invested capital opportunities, that's phenomenal!
Even better is a business with high ROIC using as little leverage as possible. In theory, if a company is successful at creating more value from a ROIC standpoint than its cost of capital, that’s a strong investment opportunity. A high ROIC is a huge tailwind that suggests an underlying quality component embedded in the business – exactly what a value investor wants. As the referenced article says, “Businesses with higher ROIC generate more free cash flow per dollar of earnings, and growth of free cash flow is what drives growth of intrinsic value!”
Indeed, return on capital is one of the core elements of value investor Joel Greenblatt’s “magic formula,” a series of calculations designed to identify high value companies available at “good” prices.
That said, we do want to do our due diligence when evaluating ROIC.
To start, we need to determine if those returns are sustainable. What if it’s just the result of a capital-intensive one-time event? Many companies are one-trick ponies who know one way to create value with their capital, but as the market fluctuates, sometimes their trick will work and sometimes it won’t. If the returns are sustainable, what makes them so? The key here is finding businesses that can continue to create value and allocate capital skillfully even as conditions change.
These questions will usually lead us into the company’s competitive advantages and whether there’s a moat that will make today’s high ROIC likely to persist.
Amazon is a good example of the relationship between return on invested capital and the ability to generate value over time.
If we go back to how Amazon traded when they were first investing in Amazon Web Services (AWS), it’s clear the market didn't give them a lot of credit for their efforts. When AWS first launched in 2006, Amazon was trading for just under $2 a share. The company was already seeing success with its invested capital even back then: in 2006, it had a healthy ROIC of 12.5% in 2006, followed by 19.2% in 2007. Even so, AWS was seen as a risky initiative for Amazon because it was a new business, and analysts/investors then didn’t see how a retailer – even an online retailer – like Amazon could have anything to do with cloud computing services. Back then, Amazon’s valuation was mostly based on what was happening with the retail business world at that time.
We now realize that was a shortsighted view. Amazon’s investment in AWS has paid off in a huge way. Today, AWS holds around a third of the cloud infrastructure services market – more than Google, Microsoft, and IBM combined. AWS contributes over half of Amazon’s operating budget. As of this writing, Amazon is trading at over $116 per share – a $5,700 increase from 2006. (For the record, it’s ROIC in 2021 was 12.6%).
Even Amazon didn’t really know what to expect out of its AWS investments initially. Amazon President and CEO Andy Jassy has said, “I don’t think any of us had the audacity to predict it would grow as big or as fast as it has.”
Back then, investors mostly just saw how the costs associated with building out AWS was hitting Amazon’s financials. A good analyst should take the income statement and be able to pull out a good snapshot of what the business is doing today and how today’s expenses are funding future growth.
For whatever reason, the market didn't really do that back then with Amazon. It clearly didn’t understand how big of a new business AWS was going to be.
Admittedly, the market isn't always great at seeing or handicapping the likelihood of success. It has a glass-half-full mentality when it comes to companies because a lot of companies just don't have the DNA to work well over time; they figured out one thing and done well but getting into a second business isn't easy. For Amazon, analysts most likely underrated the degree to which getting into cloud infrastructure was an e-retailer’s core business.
Examples in reverse might be phone makers BlackBerry Ltd. or Nokia.
In May 2008, BlackBerry was trading at $144.50. Today, it’s at $5.79, a collapse of 96%. Although BlackBerry had a healthy ROIC for many years, especially in the early 2000s, its ROIC has been in the negative for 7 out of the last 10 years. It was eclipsed by Android and the iPhone, and it couldn’t keep up. Phone manufacturer Nokia followed a similar downfall. From a 2007 high over $42 per share, it has fallen to $4.85, with negative or near-negative ROIC in eight of the last ten years. Apple’s ROIC, by contrast, has ranged between 18% and 47% during that time. (It’s worth noting that Amazon’s own attempt at a smartphone proved to be a bust … not every investment can be a winner).
Note that ROIC isn’t everything and should not be used uncritically in all situations.
For example, ROIC doesn’t work well in specific arenas, e.g., industries like financial services where capital is itself part of the product offering. It’s also important to understand that ROIC is a measure of an entire company’s performance, but it may only be a single division or segment producing the lion’s share of the returns. In other words, looking at ROIC alone can flatten our picture of a company. We should never rely exclusively on a single metric, even one as informative as ROIC.